“Mind the GAAP” – Why off-balance sheet financing is essential for retrofits

One of the main barriers to financing energy efficiency in privately owned real estate is the challenge posed by incurring additional debt.  Most privately-owned buildings are either unable to assume additional debt or are faced with difficult restrictions on taking on more debt.  Currently, the Financial Accounting Standards Board (FASB) is contemplating changing accounting standards to classify many different types of potential financing for efficiency projects as debt.

The primary change the FASB is contemplating is a convergence with the IFRS system used by the International Accounting Standards Board (as opposed to GAAP used by FASB).  The changes relate to the treatment of capital leases vs. operating leases.  Currently, capital leases qualify as debt and must be carried as a liability on a company’s balance sheet.  Operating leases are classed as off-balance sheet, and therefore do not increase the indebtedness of a company.  Under the IFRS system, operating leases are effectively removed, and all leases qualify as debt.

Most buildings are purchased through a capital structure representing a split of debt and equity.  This is similar to how a homeowner purchases a house – there is a down-payment (equity) and a loan from a bank (debt).  In the case of privately-owned real estate, the equity portion is put down by the investor, and the debt is traditionally sourced from a large lender, often an investment bank.  The primary portion of the debt, the first mortgage, has many covenants attached to it.  Covenants are conditions imposed on the owner in return for the loan.  A common covenant is that the first mortgage holder (the lender) requires the building owner to receive permission before assuming additional debt beyond some agreed upon level (generally very small).  Similarly, many loans have limits on the amount of additional indebtedness that a building can assume vs. its value or income.  Currently, a lot of commercial buildings are “underwater” because their values have fallen relative to the peak of the market when the loans were written.  The total amount of debt on the building has not changed, but the ratio of value to debt has decreased. Therefore, due to market movements, many buildings may have either passed levels of total indebtedness dictated in mortgage covenants or are significantly closer to them.

If a building owner does not want to pay cash for energy efficiency retrofits, the owner will have to seek some sort of outside financing.  Traditionally, owners have sought loans to cover additional investments, seeking to pay off the loans through the proceeds of the investment.  Given the current status of their buildings and the various covenants in the first mortgage, it is very difficult for owners to receive approval for additional loans.

It is worth noting that the securitization boom led to many mortgages now being held by a large portion of investors through the purchase of Commercial Mortgage Backed Securities.  Given the generally widely dispersed ownership of the loan, it is now incredibly difficult to modify the terms of many of these loans.  A key element to scaling investment in energy efficiency for the privately-owned real estate sector will require the development of off-balance sheet investment mechanisms.

“Mind the GAAP,” a study issued by Johnson Controls’ Institute for Building Efficiency in 2010, covers this topic very well in terms of the impact it may have on financing efficiency.  As illustrated by the study, the exact impact will vary slightly by category of building / owner type, but the impact will be quite large.

This is where off-balance sheet financing becomes so important: It allows organizations to install energy efficiency retrofits at no up-front cost and without impairing their existing debt picture, or market value. This obviates the need to go through a capital budgeting process that either does not exist or does not allow the full value of a retrofit to be realized. In effect, it fulfills the basic premise of performance contracting as a truly self-funding facilities renewal. Another perspective is that these off-balance-sheet arrangements create an opportunity for building owners and third-party asset ownership entities to effectively arbitrage the inefficiencies in utility and operating budgets by replacing old, inefficient equipment. Currently off-balance sheet structures account for only about 5% of all energy efficiency projects, although those deals tend to be much larger given the increased transaction costs (i.e., legal and accounting) associated with them. The remaining deals are all done either through capital leases or up-front purchases.

If the FASB changes go through, off-balance sheet treatment will become even more important, and more difficult to achieve.  Emerging companies such as Transcend Equity and Metrus Energy are attempting to offer innovative solutions that serve building owners.

Given the importance of off-balance sheet solutions for energy efficiency, we hope to see the development and expansion of even more options for building owners.

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One Response to “Mind the GAAP” – Why off-balance sheet financing is essential for retrofits

  1. Pingback: Transcend Equity has a big week « Financing Efficiency

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